Federal Estate Tax Update
Tree Farmer Magazine: September/October 2006 - Volume 25 No. 5
The Washington representatives of family forest owners have been working for many years to eliminate the federal estate tax. There's a good chance that they'll be able to claim a "horseshoe victory," i.e., one based on almost making a ringer. But there's a long way to go in the Senate. In this case, "almost" is $5 million, as taxable estates of up to this amount wouldn't pay an estate tax under House Bill 5638, the Permanent Estate Tax Relief Act of 2006 (PETRA). For married couples, the amount not subject to tax would be $10 million. The House passed this compromise bill in response to a request from the Senate, where the votes don't exist for permanent elimination. After gaining some perspective on the situation, let's consider what the provisions of this bill would mean.
The IRS reports that in 2004, 62,718 estate tax returns were filed. This means the gross estate was at least $1 million, since most of the returns filed in 2004 were for decedents dying in 2003, when this was the excludable amount. Forty-two percent of these, or 30,276, paid an estate tax of some amount. If the $5 million excludable amount had been applied in 2003 less than 3,500 estates would have owed any tax. If you're a cynic, you'll conclude that the major reason most estates don't pay any estate tax is because of fancy tax planning by the ultra rich, but the primary reason modest estates don't owe any tax is because of non-taxable transfers to surviving spouses and charities. Regardless, good planing to pay no more tax than is required by law is where we all should be headed. Even more importantly, estate planning is vital even if your estate falls within the excludable amount or if there was no tax at all. If you don't believe this, ask your attorney to tell you a few stories about families that fell apart because of a poor or nonexistent estate plan.
Also, whether it's millions or 3,000 estates involved, these estates represent primarily family businesses. It's difficult to make arrangements to eliminate the tax on these, and the reduction in operating assets frequently required to meet tax obligations can be devastating to the business. In addition, market-driven economies depend on the entrepreneurial activities of individuals striving to get ahead, creating jobs and economic activity in the process. But enough philosophy.
Recall that the estate tax relief provided in the Economic Growth and Tax reconciliation Act of 2001 (EGTRRA) ends after 2010. Without new legislation the estate exemption will drop to $1 million per person in 2011 and the maximum estate tax rate will increase to 55 percent. PETRA would provide permanent estate and gift tax relief. In addition to the increase in the excludable amount discussed above EGTRRA would:
Index excludable amount for inflation - The $5 million excludable amount would be indexed for inflation.
Reunify estate and gift tax - Prior to EGTRRA the estate tax and gift tax were combined at death. No gift tax was due until total taxable gifts exceeded the excludable amount. The excludable amount not used for taxable gifts was applied to amounts transferred at death. Under EGTRRA a separate $1 million exclusion applies to taxable gifts.
Reduction of estate tax rates - The rate on taxable estates of up to $25 million would be the capital gains tax rate, currently 15 percent, but set to increase to 20 percent in 2011 unless extended. The rate on taxable estates of $25 million or more would be twice the capital gains rate, making it 30 percent, but set to increase to 40 percent in 2011 unless extended.
Unused exemption carryover - Under current law if the estate of the first spouse to die doesn't fully utilize the exempt amount, any balance is lost. Under PETRA the estate of the surviving spouse could add any unused amount to their $5 million exemption. This wold greatly simplify planning for the financial needs of a surviving spouse. Currently, this is achieved through techniques such as trusts and life estates.
Full stepped-up basis - Currently, the basis of assets received from an estate is the fair market value of the asset on the decedent's date of death. This provides a benefit to almost all Tree Fram families by reducing the capital gains tax paid by heirs if they had to make a timber sale. This is often necessary to pay estate and inheritance taxes, and to provide equitable treatment to heirs not interested in an ownership interest in the Tree Farm itself. Under EGTRRA, starting in 2010, there would be a limited step-up requiring executors to allocate the available amount to specific assets in the estate. This is another complication in an already complicated process. PETRA would retain the unlimited "stepped-up" basis for property acquired from a decedent by repealing the modified carryover basis rules that would have gone into effect in 2010.
Timber Capital Gains Tax Rate for C-Corporations
In addition to the estate tax provisions, PETRA would reinstitute a capital gains income tax rate for timber disposed of by C-corporations, i.e., corporations that pay the separate corporate tax in addition to the income tax paid its owners when they receive dividends or other taxable distributions. The reduction in the effective rate would be achieved by a deduction equal to 60 percent of qualified timber capital gains. The elimination of the corporate capital gains tax rate in 1986 on timber and all other assets is one of several factors that have led, over the last several decades, to an unprecedented restructuring of the integrated forest products industry.
The article by Arno and Anderson in the July/August issue of Tree Farmer reflects, in part, the negative impact of this restructuring on Tree Farmers. In terms of increased efficiency in capital markets and the ability of the wood products industry to adjust to global markets, the restructuring is good. But ideally a tax system would be neutral, i.e., capital would be allocated by markets based on price signals, not on different tax rates for different forms of business.